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Neutral on AES Corp

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We have reaffirmed our Neutral recommendation on The AES Corporation (AES - Analyst Report) on Jan 10, 2013, given its business exposure around the globe, which insulates it from any region-specific risk. However, on the flip side, focus on long-term supply contracts exposes the company to commodity price risks rendering it incapable of passing on any escalation in prices of coal and natural gas to its customers. The company's power generation portfolio is also skewed toward coal and gas, thereby increasing the burden of green investments.

Why Maintained?

Arlington, Virginia-based AES Corporation is a global power company and is involved in the generation, distribution, transmission and selling of electricity to end-customers in the residential, commercial, industrial and governmental sectors.

AES Corporation’s businesses encompass 27 countries across 5 continents representing a highly diversified earnings base. Geographic diversity has resulted in a portfolio that is well-positioned for capitalizing on regional differences in power prices and weather-driven demand. This also insulates the company from specific risks in any single region or country.

The company is also investing a substantial portion of funds for capacity expansion in the power hungry regions of Latin American and Asia, putting the company in an advantageous position compared to its peers who remain focused on North America. Steady economic growth and power demand in the emerging markets provide an avenue to offset to some extent the continued erosion of profitability in North America.

AES Corporation has a strong balance sheet compared to its peers with a low long-term debt-to-capitalization of 67.6% at the end of the first nine months of 2012. The company closed the first nine months of 2012 with cash and cash equivalents of $1.9 billion. The company continues to be a strong cash generator, having generated operating cash flows of approximately $2.9 billion in 2011. We expect AES Corporation’s strong liquidity to stand in good stead for earnings accretive acquisitions, investments for organic growth, and its ongoing share buyback program.

On the flipside, AES Corporation’s focus on long-term supply contracts exposes the company to commodity price risk. The company would be unable to pass on any escalation in prices of coal and natural gas to its customers. Profitability at its regulated utilities depends on regular rate relief around the globe from their service countries. Further, the company’s substantial generation capacity under construction in emerging countries may face cost escalation and over-runs. This will impact the company since its earnings are fixed given its long-term delivery contracts for utility projects.

AES Corporation’s power generation portfolio is skewed toward coal and gas. Thus, the company is compelled to invest in renewable energy to meet stringent regulation standards. The company is also rapidly increasing its generation capacity and significantly focusing on fossil fuel plants. However coal prices are on the rise because of increasing demand in the emerging economies apart from higher demand from across the world. This invariably puts the additional burden of hedging on the company’s ability to smoothly run its coal-based generation assets.

Following the release of the third quarter results, the Zacks Consensus Estimate for both 2012 and 2013 remained flat at $2.73 and $3.37 per share, respectively. Also, following the third quarter earnings release, analysts apprehending a continuing trend of flat demand, weak prices and sluggish economic recovery remained on the sidelines. This is substantiated by the fact that over the past 60 days, the Zacks Consensus Estimates for both fourth quarter 2012 and full-year 2013 fell by 2 cents and 3 cents, respectively. The Zacks Consensus Estimates for fourth quarter 2012 and full-year 2013 currently stand at 30 cents and $1.22, respectively. As a result, the company now has a Zacks Rank #4 (Sell).

Other Stocks to Consider

While we prefer to remain on the sidelines for AES Corporation, there are other stocks in the sector that appear rewarding. These include Ameren Corporation (AEE - Analyst Report) and Huaneng Power International, Inc. (HNP - Snapshot Report), which are expected to perform impressively over the next few months and accordingly carry a Zacks Rank #1 (Strong Buy).

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